What if This Time is Different?What if, before the world ever heard of coronavirus, every valuation multiple suggested the U.S. stock market was one of the most expensive in history? What if these valuations assumed – and required – continued economic growth, robust increases in company earnings, and sustained and substantial stock buybacks? What if those assumptions were completely wrong?
What if the current stock market rally assumes a “Vshaped” economic recovery with lockdowns ending soon, companies rehiring employees, pharmaceutical companies developing a vaccine, and a quick “return to normalcy”? What if those assumptions are wrong?
What if lockdowns drag out, companies enter bankruptcy en masse, unemployment remains high, and households stop buying? What if retail businesses only reopen with limited capacity? What if retail businesses cannot be profitable at such capacity levels? What if landlords stop receiving rents from tenants and start losing tenants? What if some industries like hospitality and airlines take years to recover? What if even hospitals lose money since elective surgeries are nonexistent? What if even universities bleed red ink as full-tuition paying foreign students don’t return? What if other such industries perceived to be immune from this crisis fail as their most lucrative revenue streams cease to exist?
What if banks refuse to grant forbearance to landlords and companies? What if defaults skyrocket? What if banks are incapable of even understanding the damage to their loan portfolio? What if banks raise lending standards so few qualify for loans? What if banks start charging higher interest rates as they perceive increased risk? What if banks have already increased rates on their variable loans? What if banks simply stop lending? What if banks fail?
What if public pension funds fail and states cannot bail them out? What if cities file for bankruptcy? What if states must sustain prolonged unemployment benefits? What if state governments’ fiscal measures create debt levels which can never be repaid? What if these debt levels increase so much that their interest payments cannot be serviced? What if states go bankrupt?
What if the Federal Government’s own estimates are right, and it borrows almost $4 trillion this year? What if it’s more? What if the U.S. government is already insolvent? What if the lender of last resort really is the last resort? What if printing more green pieces of paper doesn’t solve these issues?
What if a recession actually started before coronavirus had infected anyone? What if an inverted yield curve, a deteriorating Cass Freight Index, and an unprecedented breakdown in the repo market suggest a recession started in late 2019 or was imminent in early 2020?
What if such a recession, rather than being a typical downturn, was one of monumental magnitude – even worse than that of the Great Recession? What if recessions are caused by increases in the money supply which artificially lower interest rates, thereby deceiving individuals and companies into making poor investment decisions? What if the Federal Reserve’s unprecedented (at the time) monetary expansion from the 2008 crisis sowed the seeds of an even greater recession today? What if all of this is happening in addition to the economic damage caused by coronavirus containment measures? What if such a recession was just getting started? What if it lasts for years?
What if a comparison of today’s financial market valuations with deteriorating economic fundamentals suggests this is greatest stock market bubble in all of U.S. history? What if bonds are not safe when money is lent to bankrupt companies and insolvent governments? What if bonds don’t protect an investment portfolio? What if stocks and bonds prove highly correlated – to the downside?
What if, after an initial bout of deflation, inflation kicks into overdrive? What if the 1970s suggest stocks and bonds can lose ground for a decade or more relative to inflation? What if most financial advisors only give lip service to inflation risk to their clients? What if their clients own no precious metals, farmland, rental real estate, or cryptocurrencies to protect them from inflation?
What if mainstream financial advisors were ultimately wrong when they said “This time is different” during the heady bull market years? What if they advise clients never to panic and never to sell? What if it is time to panic? What if it is time to sell?
What if equities crash and it takes years to recover like it has seven times over the last 100 years? What if the stock market collapses and it takes over 20 years to break even as it did after 1929? What if retirement-age workers can no longer afford to retire?
What if this time is not different?
What if most financial advisors are telling clients to buy the dip? What if they are telling investors the markets always rebound and the economy always quickly recovers? What if investors are conditioned to believe them based upon their experience with the 2008 crisis?
What if this time is different?
About WindRock
WindRock Wealth Management is an independent investment management firm founded on the belief that investment success in today’s increasingly uncertain world requires a focus on the macroeconomic “big picture” combined with an entrepreneurial mindset to seize on unique investment opportunities. We serve as the trusted voice to a select group of high-net-worth individuals, family offices, foundations, and retirement plans.
All content and matters discussed are for information purposes only. Opinions expressed are solely those of WindRock WealthManagement LLC and our staff. The material presented is believed to be from reliable sources; however, we make no representations as to its accuracy or completeness. All information and ideas presented do not constitute investment advice and investors should discuss any ideas with their registered investment advisor. Fee-based investment advisory services are offered by WindRock Wealth Management LLC, an SEC-Registered Investment Advisor. The presence of the information contained herein shall in no way be construed or interpreted as a solicitation to sell or offer to sell investment advisory services. WindRock Wealth Management may have a material interest in some or all of the investment topics discussed. Nothing should be interpreted to state or imply that past results are an indication of future performance. There are no warranties, expresses or implied, as to accuracy, completeness, or results obtained from any information contained herein. You may not modify this content for any other purposes without express written consent.
GDP purports to measure economic activity while largely divorcing itself from the quality, profitability, depth, breadth, improvement, advancement, and rationalization of goods and services provided.
For example, even if a ship — built at great expense — cruised without passengers, fished without success, or ferried without cargo; it nevertheless contributed to GDP. Profitable for investors or stranded in the sand; it added to GDP. Plying the seas or rusting into an orange honeycomb shell; the nation’s GDP grew.1
Stated alternatively, GDP fails to accurately assess the value of goods and services provided or estimate a society’s standard of living. It is a ruler with irregular hash marks and a clock with erratic ticks.
As proof, observe this absurdity: in 1990, Soviet GDP equaled half of US GDP, according to the 1991 CIA Factbook. No one visiting the Soviet Union in 1990 would believe their economy came close to 50 percent of the quality and quantity of the goods and services produced in America. GDP-defined production may have been strong, but laying roads to nowhere, smelting unusable steel, and baking barely edible breads stretches the definition of “production.” And this describes the goods which were actually produced. There is no accounting for the opportunity cost of forfeited essential goods and services.
How can this be? Why does GDP poorly reflect economic size and vitality? The blame largely resides with three fallacious concepts embedded within GDP “measurements”:
(1) intermediate goods (e.g., steel) must be eliminated to avoid “double counting”; (2) government expenditures consist of viable economic activities; and (3) imports should be netted against exports.
The Overstatement of Consumption
Which transactions should be included within GDP? Since most products consist of other products, GDP architects attempt to avoid “double counting” transactions by largely including only final goods and services produced. By their methods, the production of a car is counted (as an increase in inventory), but the metal, rubber, and plastic purchased in its creation is not. But the rules behind what makes a transaction “final” are arbitrary. The logic could just as easily justify including the sale of an automobile to a consumer and disregarding its previous production. In addition, any “final” transaction during a given time period does not necessarily include intermediate goods produced in that same time period: metal, rubber, and plastic purchased today will likely be for a different car produced or sold in a different (future) time period.
Regardless as to the arbitrary nature of determining final sales and notwithstanding the problem of temporally matching intermediate goods with their associated final sales, the exclusion of certain “intermediate” transactions simply excludes massive volumes of economic activity. Thus, GDP understates the economy as a whole while grossly overstating its consumption component relative to business investment. A better measure of overall production was employed in 2014, after years of urging from Mark Skousen, when the US Commerce Department began publishing Gross Output which incorporates intermediate transactions. Using Gross Output, the commonly cited statistic of consumption accounting for 70 percent of all economic activity quickly falls to a mere 40 percent.
The Treatment of Government Expenditures as Productive
If GDP purports to measure economic activity which benefits society, the inclusion of government expenditures is dubious. GDP “produced” in the Soviet Union is no different than GDP “produced” by any government — the difference is but one of scale. All government spending is to some degree malinvestment, for as Murray Rothbard noted:
Spending only measures value of output in the private economy because that spending is voluntary for services rendered. In government, the situation is entirely different … its spending has no necessary relation to the services that it might be providing to the private sector. There is no way, in fact, to gauge these services.
The absence of voluntary action renders prices impotent, and without true price discovery, benefits cannot be ascertained. This does not mean all goods and services provided by government would cease to exist; rather, some production (e.g., hospitals, schools, roads, etc.) would revert to the private sector. To the extent government expenditures for goods and services would be produced by the free market, the true government contribution to GDP may be positive but overstated (it currently approximates 20 percent of US GDP). A more accurate depiction of economic activity would reduce if not eliminate the contribution of government expenditures. Or perhaps, as Rothbard argued, the higher of government receipts or expenditures should actually be deducted from GDP since “all government spending is a clear depredation upon, rather than an addition” to the economy.
The Problems of Subtracting Imports from Exports
As Robert Murphy has noted several times, the netting of imports against exports in determining GDP seriously understates the contribution of trade to overall economic activity. To wit, an economy which exports $1 and imports $1 will have the same GDP contribution (zero) as one which exports $100 billion and imports $100 billion. Obviously, the latter economy would be far worse off with the sudden cessation of trade.
A fixture of GDP is the mercantilist mentality of treating exports positively and imports negatively. Why are exports additive to GDP while imports are deductive? If the goal of GDP is to measure the goods and services provided to people within a geographic region, imports — not exports — are the benefit. Exports are but payment for imports. The problem and confusion arises because the GDP calculation unrealistically excludes other forms of payment: it should make a difference if imports are funded with increasing debt levels or if funds are accumulated from previous years of compensated exports. If China converted over $1 trillion in US debt instruments into imports of American goods and services, its people benefit today, but under GDP accounting, the negative impact of imports would offset greater consumption and/or government spending (the increase in GDP was previously realized in the years during which exports created a trade surplus).
GDP is Designed to Advance the Keynesian Agenda
Simon Kuznets (1901–1985) revolutionized econometrics and standardized measurements of GDP, with his research culminating in his 1941 book, National Income and Its Composition, 1919–1938. While not a Keynesian per se, the nature and timing of his research fueled the Keynesian revolution since central planning requires economic statistics. As Murray Rothbard noted:
Statistics are the eyes and ears of the bureaucrat, the politician, the socialistic reformer. Only by statistics can they know, or at least have any idea about, what is going on in the economy. Only by statistics can they find out … who “needs” what throughout the economy, and how much federal money should be channeled in what directions.
GDP’s faulty theoretical underpinnings and politically motivated acceptance distort the performance and nature of an economy while failing to satisfactorily estimate a society’s standard of living. In fact, Kuznets partially understood this. In his very first report to the US Congress in 1934, Kuznets said “the welfare of a nation [can] scarcely be inferred from a measure of national income.” Yet the blind usage of GDP persists. That its permanence and persistence only serves the Keynesian policies of greater consumer spending, increased government expenditures, and larger exports through currency debasement should not be considered coincidental. Unfortunately, the resulting economic stagnation, debt accumulation, and price inflation are as inevitable as they are predictable.
Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
Endnotes:
Starting in December of 1991, the Bureau of Economic Analysis (BEA) of the U.S. Department of Commerce emphasized gross domestic product (GDP) over that of gross national product (GNP) as a measurement of production within the U.S. The difference between GNP and GDP lies in the treatment of income from foreign sources: GNP measures the value of goods and services produced by U.S. nationals, while GDP measures the value of goods and services produced within the boundaries of the U.S., regardless as to the nationality of ownership. For purposes of this article, the differences between each measurement are unimportant and therefore “GDP” is utilized synonymously with GNP.
How This Plays Out: An Interview With James Rickards
The pandemic and corresponding draconian containment efforts have created an economic and financial situation unseen since the Great Depression. Everyone wants to know whether the economy will rebound quickly or if we will experience a prolonged recession.
How does this play out?
Noted financial expert James Rickards foresaw such economic calamity last year when he wrote Aftermath: Seven Secrets of Wealth Preservation in the Coming Chaos.
Mr. Rickards joins WindRock to discuss:
Why the current financial situation is unlike the 2008 financial crisis;
What impact the recently passed CARES Act will or will not have on the economy and various investments;
How far equities may still fall despite their recent rally; and
Which asset classes investors should consider to shield themselves from economic and financial calamity.
April, 2020
Should Investors Consider Cryptocurrencies?
Christopher P. Casey
This article was originally published by Citywire RIA in March 2021
Absolutely! We have been writing about and advising clients on cryptocurrencies since 2014. Cryptocurrencies possess the breakthrough capabilities of blockchain peer- to-peer technology, namely: digitizing assets for better security, transparency, and transactional efficiency. No matter what the application, the underlying thesis behind all blockchain varieties is the same: a disruptive technology which cuts out the middleman to provide exponential benefits. Bitcoin, in acting as a monetary substitute while sporting a market capitalization approaching $1 trillion, is simply the first cryptocurrency to be validated by the marketplace. It should be considered by every financial advisor.
Why? As always, simply look to demand and supply. Bitcoin now has a strong institutional infrastructure with futures offered by the CME and Bakkt (in part owned by the NYSE’s owner, Intercontinental Exchange), newly viable custodian options, and better regulatory certainty. Accordingly, institutional demand has taken off, ranging from dynamic hedge funds, to entrepreneurial Tesla, to mainstream mutual funds, and even to insurance companies like MassMutual. Retail investors have followed suit given easier access and increased security due to custodial “cold wallets” and theft insurance. Largely driving bitcoin demand for all parties is the recognition of bitcoin as a legitimate inflation hedge.
And given the Federal Reserve’s newfound commitment to increased inflation, they should. One needs only to look to Federal Reserve balance sheet growth for an ominous warning: according the Federal Reserve, its assets (from printing money out of thin air) increased over 76% from $4.3 trillion in mid-March 2020 to $7.6 trillion today. How does that increase in the supply of dollars stand in relation to the supply of bitcoin?
The answer: in sharp contrast. The most bitcoins which can be “mined” (created) are limited to 21 million (and over 18 million exist today). Just as importantly, the rate of bitcoin creation is decreasing as rewards for mining bitcoin are periodically diminished by 50% (known as a “halving”). Constrained supply combined with rising demand should result in continued, albeit potentially volatile, long-term bitcoin price appreciation.
Detractors often characterize cryptocurrency investing as “speculative” given its dramatic volatility. Have individual stocks not experienced similar declines? It should be remembered that bitcoin has existed for over 12 years and, despite dramatic drawdowns along the way, has proven itself resilient.
Critics also dismiss bitcoin and other cryptocurrencies since they lack “tangible” value. But how much tangible value is there in most software companies? How about financial derivatives? How about the dollar?
Yes, there will be winners and losers in the cryptocurrency universe. It is very comparable to investing in the early days of the Internet. But bitcoin and cryptocurrencies are legitimate investments and deserve consideration in every investor’s portfolio. RIAs who refuse to consider them are doing their clients a disservice.
About WindRock
WindRock Wealth Management is an independent investment management firm founded on the belief that investment success in today’s increasingly uncertain world requires a focus on the macroeconomic “big picture” combined with an entrepreneurial mindset to seize on unique investment opportunities. We serve as the trusted voice to a select group of high-net-worth individuals, family offices, foundations and retirement plans.
This article was originally published byThe Ludwig von Mises Institute of Canada on April 18, 2017
Every year, airlines deny thousands of passengers seats on flights due to overbooking. Airlines use sophisticated modeling to manage overbooking to maximize profits given the reality of passenger no- shows. Legally permissible under their “contract of carriage” with passengers, fewer than one-tenth of one percent of all passengers lose seats due to overbooking. 1 But when Dr. David Dao was violently removed from a United Airlines flight in Chicago, it did far more than generate a public relations nightmare; it exposed the absurdity of fractional reserve banking.
If an airline had 100 seats and overbooked by 10, then 91% of their seats are “reserved”. U.S. banks need only retain an effective 10% of demand deposits on hand for withdrawals while Canadian banks have no reserve requirement. Baring general capital requirements, the remainder can and is typically lent to borrowers. If an airline used 10% fractional reserve seating, the number of stranded passengers would approach 900 for a 100-seat airplane. The refugee-like look of an airline gate under such a situation would be no different than the typical bank run during the Great Depression.
Unfortunately, just as passengers lack legal recourse when denied seats, demand depositors cannot seek redress when their withdrawals are refused. As Murray Rothbard detailed in The Case Against the Fed and his other books on the history of banking, it was unfortunate 19th-century case law ceased recognizing a deposit as a bailment (the custody of another’s possessions). As Rothbard opined, the legal cover given fractional reserve banking cannot mask the fraudulent nature of lending against demand deposits. And no “contract” between a depositor and a bank can legitimize fractional reserve banking, just as naming something a “square circle” cannot create such a shape.
Even people versed in Austrian economics fail to understand the nature of fractional reserve banking. In an August 17, 2014 Forbes article entitled The Closing of the Austrian School’s Economic Mind, columnist John Tamny wrote:
“This alleged “multiplication” of money all sounds so frightening at first glance, but for those who think there might be some truth to the “money multiplier,” DO try it at home among friends. Hand the first friend $1,000, and let him lend $900 to the person next to him, followed by an $810 loan to the next tablemate. What those who try it will find is that far from creating $2,710 worth of access to the economy’s resources, there will still be only $1,000; the original holder of $1,000 with $100 in his possession, $90 in the second person’s hands, followed by $810 in the third.”2
And yet this illustration proves the opposite of Tamny’s conclusion, for the money supply is not just the physical dollars on the table. If the arrangements between the participants allow for withdrawals on demand, then each person would assume their cash balances equaled their cash on hand as well as their “demand deposit” with the next person. The money supply would absolutely equal $2,710 with only $1,000 in physical currency.
Although few understand fractional reserve banking, even fewer appreciate its repercussion. So while Dr. Dao could passively resist fractional reserve airline seats, none of us can escape the business cycles and price inflation caused by fractional reserve banking.
About the Author:Christopher P. Casey, CFA®, is a Managing Director with WindRock Wealth Management. Mr. Casey advises clients on their investment portfolios in today’s world of significant economic and financial intervention. He can be reached at 312-650-9602 or chris.casey@windrockwealth.com.
WindRock Wealth Management is an independent investment management firm founded on the belief that investment success in today’s increasingly uncertain world requires a focus on the macroeconomic “big picture” combined with an entrepreneurial mindset to seize on unique investment opportunities. We serve as the trusted voice to a select group of high net worth individuals, family offices, foundations and retirement plans.
All content and matters discussed are for information purposes only. Opinions expressed are solely those of WindRock Wealth Management LLC and our staff. Material presented is believed to be from reliable sources; however, we make no representations as to its accuracy or completeness. All information and ideas should be discussed in detail with your individual adviser prior to implementation. Fee-based investment advisory services are offered by WindRock Wealth Management LLC, an SEC-Registered Investment Advisor. The presence of the information contained herein shall in no way be construed or interpreted as a solicitation to sell or offer to sell investment advisory services except, where applicable, in states where we are registered or where an exemption or exclusion from such registration exists. WindRock Wealth Management may have a material interest in some or all of the investment topics discussed. Nothing should be interpreted to state or imply that past results are an indication of future performance. There are no warranties, expresses or implied, as to accuracy, completeness or results obtained from any information contained herein. You may not modify this content for any other purposes without express written consent.
Endnotes:
1Ben-Achour, Sabri. “Why in the world do airlines overbook tickets?” Marketplace. 27 April 2015. https://www.marketplace.org/2015/04/27/business/ive- always-wondered/why-world-do-airlines-overbook-tickets.
2 Tamny, Joh. “The Closing of the Austrian School’s Economic Mind” Forbes. 17 August 2014. https://www.forbes.com/sites/johntamny/2014/08/17/the- closing-of-the-austrian-schools-economic- mind/#36b63f455147
Don’t Forget About the Trade War
Christopher P. Casey
This article was originally published by the Mises Institute on February 27, 2020
Before coronavirus and impeachment, the Sino- American trade war stubbornly remained on the mainstream news circuit while largely governing the direction of financial markets. With each rumor of concession or tweet of condemnation, stocks gyrated and bonds jittered. Each round of negotiation was been matched by salvos of tariffs, export controls, lawsuits, complaints, declarations, and threats. At its peak, the U.S. imposed tariffs on $550 billion of Chinese imports while China retaliated with tariffs on $185 billion of U.S. goods.1
With its early 2018 inception, many mainstream pundits and commentators agreed with President Trump that the trade war would be beneficial (or at least benign) and short (otherwise it would not be “easy to win”).2 But the trade war, albeit in fits and starts, continued, escalated, and now largely sits in stalemate – despite the “Phase One” agreement – with no clear visibility of resolution. Even with a recent reprieve, the trade war will likely continue for the foreseeable future with great risk to economies and financial markets.
Why Trump Will Likely Continue the Trade War
Some argue that President Trump is actually in favor of free trade but wishes to renegotiate various trade treaties. That is, by embracing protectionist policies, free trade can later be broadened on more “appropriate” terms. For example, some of the stated NAFTA renegotiation objectives included the elimination of “unfair subsidies, market-distorting practices by state owned enterprises, and burdensome restrictions on intellectual property.” But this interpretation is contrary to significant evidence which indicts Trump as a devoted protectionist.
Trump’s overall political philosophy is revealed by his pre-Presidential talk show confessions. The future President hit the talk show circuit extensively in the 1980’s and 1990’s by appearing on such shows as David Letterman, Oprah Winfrey, Phil Donahue, and Larry King. These interviews provide an insightful look into his core beliefs. Consistently, the most passionate commentary concerned foreign nations “taking advantage” of the U.S. – either by failing to contribute more to their own national defense or by running significant trade surpluses (U.S. trade deficits). In these interviews, the ire from the latter of these was usually directed (given the time) at Japan. Today it is China.
Trump clearly views trade in a zero-sum, mercantilist manner with the country possessing a deficit as “losing” and “down.” In mid-2019, the President tweeted the following:
When a country . . . is losing many billions of dollars on trade with virtually every country it does business with, trade wars are good when we are down $100 billion with a certain country and they get cute, don’t trade anymore-we win big. It’s easy.3
Four other facts buttress Trump’s position as an ardent protectionist. First, protectionism is theoretically consistent with President Trump’s immigration position. If one believes immigrants take away American jobs, then logically one would also fear cheaper foreign goods which destroy the profitability of American companies – and by extension, cost U.S. workers their jobs.
Second, while the protectionist measures enacted so far have been focused on China, they have also, to a lesser extent, been levied against allies (e.g., Canada, Europe, etc.). This is why, when signing the new U.S.-Mexico- Canada Agreement in January, President Trump noted the agreement was “finally ending the NAFTA nightmare.”4
Third, President Trump, almost immediately upon taking office, pulled out of the Trans-Pacific Partnership negotiations. While one could easily argue this agreement actually hindered free trade given its excessively burdensome and complex rules and regulations, the rationale given for withdrawing was a protectionist argument: the preservation of American manufacturing.5
Fourth, he has surrounded himself with advisors notorious for their protectionist policy advocacy. Most notable among them are economist Peter Navarro who authored the book Death by China and Commerce Secretary Wilbur Ross.
Today’s political climate only serves to facilitate Trump’s protectionist philosophy. In addition to this year’s election and the likely need to secure Rust Belt electoral votes, anti-China rhetoric and positioning are popular with both political parties and the deep state.
Why China May Wait for the 2020 – or 2024 – Election
As any future trade agreement will decrease free trade (at least compared to the pre-trade war environment), any likely agreement will be, by definition and on the whole, deleterious to both countries to the advantage of certain industries, businesses, and/or occupations (including political offices). China singularly understands the benefits of free trade and stands to lose its prosperities as well as be burdened by any ancillary labor, intellectual property, or environmental provisions. It is in their interest to delay and forestall any agreement.
This strategy coincides nicely with two Chinese concepts: “saving face” and a “holistic” negotiating style. The concept of “face” refers, loosely, to the Sino- cultural understanding of respect, honor, and social standing. President Trump, with bombastic boasts and brash bargaining, only forces President Xi and Chinese leadership into steadfast positions.
It is culturally, and thus politically, difficult for the prospects of any agreement if it appears to be an American victory. This applies to both intra-regime circles (leadership struggles) and with the government vis-à-vis the populace. The former is exacerbated by the pageantry and intrigue of next year’s Communist party centenary. The latter of which is intensified by leadership’s keen sensitivity to Chinese society’s long- held belief in the “Mandate from Heaven” (the loss of which is frequently signaled by Heaven through such natural disasters as epidemics – especially untimely given both the onset of coronavirus and the perception of an inept government response).
Holistic negotiating style, or zhengti guannian, is a well-known and often frustrating exercise for any westerner having done business in China. As described in a Harvard Business Review article:
. . . the Chinese think in terms of the whole while Americans think sequentially and individualistically, breaking up complex negotiation tasks into a series of smaller issues: price, quantity, warranty, delivery, and so forth. Chinese negotiators tend to talk about those issues all at once, skipping among them, and, from the Americans’ point of view, seemingly never settling anything.6
This concept has already manifested itself in the trade war; it is not uncommon for U.S. to believe an agreement has been reached only to be met by silence or denials from the Chinese.
Will the Trade War Cause a Recession?
If the trade war escalates, can it directly cause a U.S. economic recession? Many mainstream pundits, citing the infamous Smoot-Hawley Act of 1930, warn as such (which is odd, especially since the Great Depression was well underway before it was enacted let alone took effect).
But tariffs may indirectly cause a recession. As recessions are caused by malinvestment (investments unjustified by the natural level of interest rates) created through artificially suppressed interest rates, then rising rates may serve to expose this malinvestment and force its liquidation (e.g., business closures, layoffs, bankruptcies, etc.) – also known as a recession.
Currently, U.S. Treasury debt held by China approximates $1.1 trillion.7 Curtailing future purchases and/or programmatically selling these holdings may increase interest rates dramatically (from where they would otherwise be, all things being equal). Many pundits cite the unlikelihood of this by noting such sales would decrease bond prices and thus the value of China’s U.S. Treasury holdings. But the impact on U.S. interest rates need not result from a “liquidation” by China; rather, since all prices are determined at the margin, decreased demand or increased supply (sales) by China – evenly seemingly insignificant, may raise rates.
If the trade war turns to financial warfare tactics, both sides are more likely to receive recession than resolution.
About WindRock
WindRock Wealth Management is an independent investment management firm founded on the belief that investment success in today’s increasingly uncertain world requires a focus on the macroeconomic “big picture” combined with an entrepreneurial mindset to seize on unique investment opportunities. We serve as the trusted voice to a select group of high-net-worth individuals, family offices, foundations and retirement plans.
Wong, Dorcas and Koty, Alexander. “The U.S.-China Trade War: a Timeline” China-Briefing. 7 February 2020. https://www.china- briefing.com/news/the-us-china-trade-war-a-timeline/
Trump, Donald. Twitter: @realDonaldTrump. 2 March 2018.
Graham, John and Lam, Mark. “The Chinese Negotiation” Harvard Business Review. 1 October 2003. https://hbr.org/2003/10/the- chinese-negotiation
Treasury International Capital (TIC) System. U.S. Department of the Treasury. 17 February 2020. https://www.treasury.gov/resource- center/data-chart-center/tic/Pages/index.aspx
Donald Trump’s Whig is Showing
This article was originally published by the Mises Institute on March 21, 2017
On February 28th, while addressing a joint session of Congress, President Trump quoted Abraham Lincoln and praised his economic philosophy:
The first Republican President, Abraham Lincoln, warned that the “abandonment of the protective policy by the American Government [will] produce want and ruin among our people.”
Lincoln was right — and it is time we heeded his words. I am not going to let America and itsgreat companies and workers, be taken advantage of anymore.1
In channeling Lincoln, Trump underscored the reversion of the Republican Party to its economic roots, which embraced protectionism, state-sponsored infrastructure spending, and central banking. While a new party in Lincoln’s day, its economic philosophy derived directly from the Whig Party and its champion, Henry Clay.
Thomas DiLorenzo’s excellent book, The RealLincoln, chronicles and exposes the Republican-Whig economic platform, known then as the “American System” (the local flavor of mercantilism).2 While it is unlikely Lincoln addressed the issue of slavery before 1854, he constantly discussed and advocated the American System. As early as 1832, he called for an “internal improvements system and a high protective tariff.” The “improvements” specifically referred to the infrastructure of the day: railroads, shipping, and canals. The Republican Party, in its 1860 platform, devoted three of its 17 “declarations” to advocating the American System. Declaration 12 called for duties on imports to “encourage the development of the industrial interests of the whole country.” Declaration 15 advocated “appropriations by Congress for river and harbor improvements of a national character.” And declaration 16, after noting the importance of a railroad to the Pacific Ocean, recommended “that the federal government ought to render immediate and efficient aid in its construction.”3
Wigs may come in and go out of fashion, but the economic policies of Whigs endure. Unfortunately, the dangers of Whig economic folly and fallacy do not diminish with time.
Protectionism seeks to increase trade surpluses or lower trade deficits by taxing imports (tariffs) or banning or limiting the quantity of imports (quotas). A simple examination of any individual import transaction quickly exposes the folly of protectionism. If an American buys a Japanese car, the Japanese auto manufacturer then owns U.S. dollars. These dollars can be used in three ways:
Increase dollar holdings;
Sell the dollars to another foreign country for goods, services, or capital (in which case the buyer of U.S. dollars faces the same three choices); or
Purchase U.S. goods, services, or capital (e.g., real estate or Treasuries).
When looked at this light, unless the Japanese auto maker maintains the dollars in perpetuity (in which case America literally received a car for green-dyed paper), the export of dollars must be matched by an American export or an investment by the foreigner in America. Arbitrarily dividing the former as trade while the latter as a capital flow creates the appearance of trade deficits and capital surpluses.
Historically, American imports have been largely financed through foreign investments in America. Chronic American trade deficits are offset by repetitive capital surpluses. In a free market, there is nothing inherently wrong with such a situation.
Protectionism may alter (a.k.a. distort) trade balances and capital flows, but only at the expense of the wealth of all trading partners. This can be readily discerned if protectionism is taken to its logical extremes. Would the American standard of living be enhanced by a self-imposed blockade or with trade barriers erected between each of the 50 states? If these extreme policies would bring economic “want and ruin”, then enacting lighter versions of the same policies brings but less damage.
Underlying such common-sense arguments is the law of comparative advantage, ascribed to but only loosely championed by David Ricardo. Most economists of Adam Smith’s era believed in the doctrine of absolute advantage: the idea that countries should specialize in their best or most efficient product. In An AustrianPerspective on the History of EconomicThought, Murray Rothbard described the importance of the law of comparative advantage:
The law of comparative advantage . . . is . . . indispensable to the case for free trade. It shows that even if, for example, Country A is more efficient than Country B at producing both commodities X and Y, it will pay the citizens of Country A to specialize in producing X, which it is most best at producing, and buy all of commodity Y from Country B, which it is better at producing but does not have as great a comparative advantage as in making commodity X.
In other words, each country should produce not just what it has an absolute advantage in making, but what it is most best at, or even least worst at, i.e. what it has a comparative advantage in producing.4
The law of comparative advantage describes how all countries, regardless as to productive capabilities or wealth, benefit from trade.
The Fallacy of Trump’s State-Sponsored Infrastructure Spending
The magnitude of the new administration’s infrastructure proposals will be substantial and far more important than the form it takes (e.g., outright budgetary spending, loan guarantees to private firms, tax incentives, etc.). In his recent speech to the joint session of Congress, President Trump called for “legislation that produces a $1 trillion investment.”5 From the canals and railroads of Lincoln to the airports and pipelines of Trump, history has repeatedly demonstrated the product of state-sponsored infrastructure spending: boondoggles.
How can government officials determine how many runways an airport requires or how long or to where a pipeline should extend absent prices? Without private property, which
generates prices and correspondingly, profit and loss, an economic fog descends which clouds all decision making. In this context, government officials determining infrastructure spending are no different than a Soviet official deciding how much wheat to plant, which shoes and shoe sizes should be produced, or how much caviar to pull from the Caspian Sea. And the results will be the same.
Central Banking Supports Protectionism and State-Sponsored Infrastructure Spending
Protectionism and state-sponsored infrastructure spending are hallmarks of the Trump administration’s economic policy, and two of the three planks of the American System. The third, central banking, is no longer an active political issue, but it is pivotal in supporting and expanding the others by facilitating and coordinating monetary inflation.
Monetary inflation covertly creates and enhances protectionism by increasing exports at the expense of importers and consumers. Likewise, in substituting monetary inflation for taxation, central banking obscures the true costs and payers of state-sponsored infrastructure spending. If one substitutes exporters and crony capitalists for the Royal Air Force in Winston Churchill’s famous quote, it well summarizes the benefits and costs of the American System: “Never . . . was so much owed by so many to so few.”6
Conclusion
In 1858, Lincoln famously echoed the Bible in stating “a house divided against itself cannot stand.”7 American society, with the election of President Trump, is surely divided against itself. But a society’s level of division directly corresponds to the level of government interference in the economy. The more a government interferes and diminishes the overall level and growth rate of wealth, the greater will be the divided house. Without the American System, divisions would dissipate as free trade, private financing of infrastructure, and sound money reward all of merit and raise the standard of living for all.
Today, the American System is, sadly, once again American.
About the Author:Christopher P. Casey is a Managing Director with WindRock Wealth Management. Mr. Casey advises clients on their investment portfolios in today’s world of significant economic and financial intervention. He can be reached at 312-650- 9602 or chris.casey@windrockwealth.com.
WindRock Wealth Management is an independent investment management firm founded on the belief that investment success in today’s increasingly uncertain world requires a focus on the macroeconomic “big picture” combined with an entrepreneurial mindset to seize on unique investment opportunities. We serve as the trusted voice to a select group of high net worth individuals, family offices, foundations and retirement plans.
All content and matters discussed are for information purposes only. Opinions expressed are solely those of WindRock Wealth Management LLC and our staff. Material presented is believed to be from reliable sources; however, we make no representations as to its accuracy or completeness. All information and ideas should be discussed in detail with your individual adviser prior to implementation. Fee-based investment advisory services are offered by WindRock Wealth Management LLC, an SEC-Registered Investment Advisor. The presence of the information contained herein shall in no way be construed or interpreted as a solicitation to sell or offer to sell investment advisory services except, where applicable, in states where we are registered or where an exemption or exclusion from such registration exists. WindRock Wealth Management may have a material interest in some or all of the investment topics discussed. Nothing should be interpreted to state or imply that past results are an indication of future performance. There are no warranties, expresses or implied, as to accuracy, completeness or results obtained from any information contained herein. You may not modify this content for any other purposes without express written consent.
Adding Austrian Economics
The following is a transcript of a speech by Christopher Casey of WindRock Wealth Management to the Mises Institute’s 2016 Supporters Summit held on September 17th in Asheville, North Carolina.
In thinking about the title of this presentation, it occurred to me that some people may be uninterested. That is, attendees may feel they manage their own investments, and are therefore unthreatened by wealth managers ignorant of Austrian economics.
Fortunately, in the last several weeks, we have learned that a certain major bank has been kind enough to open multiple accounts for each and every person in this room.
So, it turns out you actually are at risk. We are living in a distinctive time period, which has introduced terms as unique as they are dangerous. Terms like negative interest rates, excess reserve balances, and quantitative easing.
I wish I could say we live in unparalleled times, and it is true that this economic situation is unique, but there are parallels in the magnitude of its gravity. Dates like 1928 and 2007 come to mind.
And no election will bring relief: we are faced with the choice between a man who frequently displays errors of judgement and a woman whose judgement is consistently in error.
I do not need to remind this audience of the worldwide economic situation that threatens the livelihoods of billions. But there is another danger lurking. One that threatens billions in savings. Actually, trillions. As Jeff Deist noted last night, the economics profession is broken. The same can be said for the wealth management industry. But while government officials, crony capitalists, and to a large degree, mainstream economists are motived by greed and power, the beliefs of wealth managers are driven by cowardice and ignorance. And this is evident from every phrase they utter.
The cowardice is evident from their 2009 chorus of “no one saw this coming” to their mantra of “you can’t time the market.”
The ignorance is apparent when they use phrases such as an “overheated economy.”
So, allow me to review some of the mistaken beliefs held by wealth managers, and how it impacts one’s portfolio.
First, price inflation. A word which used to be feared, but now is strangely welcomed by government officials.
Wealth managers speak of it even less than they understand it. They may have some vague understanding that it has something to do with the quantity of dollars which exist. They probably learned a phrase from a famous but flawed economist that:
“Inflation is always and everywhere a monetary phenomenon.”
But what does that really mean? It’s like saying ice and snow are always an everywhere a temperature phenomenon.
It doesn’t tell us much, because the statement’s truth is as selfWevident as it is incomplete.
Despite the massive increase in the money supply, wealth managers are unconcerned about inflation. They believe that, as long as wage and cost pressures are manageable, the economy will not “overheat.”
For the record, the ONLY thing on this earth less likely to become overheated than an economy . . . is someone trying to hide a serious illness while running for President.
If you ask a wealth manager what they mean by “overheating”, most cannot answer the question. Analogies are great to illustrate concepts, but this analogy has replaced the concept itself.
What they are trying to articulate is the classic theory of “demandWpull” inflation. It is the belief that until high employment levels and high factory utilization are achieved, prices will not rise.
Recessions and weak economic growth preclude inflation because aggregate demand, whatever that is, fails to increase substantially.
But apparently, no wealth manager lived through the 1970’s, because that’s exactly what we had.
They also do not fear inflation because commodity prices such as oil and agricultural products are low. In their paradigm, inflation occurs when costs rise and ultimately bubble up to consumer prices.
But if the price of oil or some other costWpush culprit rises, the buyers have less money to spend on other goods and services. Having less money to purchase something means less demand exists, and decreased demand reduces prices.
So, while some prices go up, it is at the expense of other prices which go down. Ultimately, no net effect to the overall price level.
We can see this with their false villain for the price inflation of the 1970’s: oil. The oil price increase in the 1970’s was certainly dramatic, but the price of oil has experienced equally pronounced changes in prices over the last decade or so as well.
Has the overall price level changed accordingly? Has the
U.S. economy experienced significant inflation and deflation as oil moved from $25 in April 2003 up to $133 in July 2008, down to $40 in December 2008, back up to $125 in March 2012, and down to less than $30 earlier this year?
Does anyone remember the price level gyrating like that over the last decade or so?
As if these misconceptions by wealth managers are not enough, they also do not believe we will have inflation as long as the “velocity” of money stays low.
I find this belief particularly odd. How can dollars independently create prices without the goods or services with which they transact?
The idea of velocity derives from an equation popularized in the early part of the 20th century by the economist Irving Fisher to explain the price level. But it originally derived from, of all people, Copernicus. However, while he was correct about that Sun thing, he was wrong about this.
The flaw is that velocity is not a proxy for the demand for money. If anything, maybe we can say it represents volume. And the volume of transactions has no bearing on prices. Strange that wealth managers do not apply their velocity theory to the stock market: they talk about weak or high volume, but no one says weak or high volume causes stock indices to move up or down.
Austrian economic theory proposes that money, like any other good, has a price set by supply and demand. So, any theory of a price level – which is another way of saying a theory of the value of money – which ignores demand is flawed.
If wealth managers really think low monetary velocity is keeping a lid on inflation, they will be surprised when inflation eventually skyrockets despite low velocity.
So not only do wealth managers fail to prepare portfolios for any possible inflation, but the concept of inflation is so alien to them, they neglect to convey its effects when determining investment returns.
Wealth managers are equally unable to explain recessions.
All of us are familiar with the basic outline of Austrian business cycle theory: artificial increases in the money supply lowers interest rates below their natural levels which induces economic actors to make malinvestments which are ultimately revealed in a recession.
A few wealth managers may subscribe to a Chicago school or Keynesian business cycle theory, but many believe recessions are natural outgrowths of the free market and are, in fact, unexplainable.
They cannot explain the widespread and severely erroneous judgment of businesses in forecasting the future as revealed in the “bust”.
They cannot explain why it is a cycle, and why this cycle first appeared in the 19th century.
They cannot explain why capital goods industries are more sensitive to booms and busts relative to consumer goods industries.
They cannot explain why significant money supply expansion precedes every single recession. But the wealth management industry’s ignorance about the causation of business cycles is surpassed by their misunderstanding of recession remedies.
As Austrians, we know one directive should be followed by policy makers in a recession: do not interfere with the economy’s adjustment process.
Do not prevent the liquidation of assets or companies with bailouts. Do not stimulate consumption and discourage savings through deficits and other means. And above all, do not inflate the money supply again which will only bring another recession in the future.
Because wealth managers do not have an adequate theory of what causes recessions, they applaud the standard recipe used to deal with economic downturns: big bailouts, huge deficits, and massive monetary expansion.
It is to the point now where they buy stocks and bonds solely in reaction to Federal Reserve action. Or better stated, inaction.
It is to the point now where the interpretation of Federal Reserve policy is as delicate and important a science as that of the Kremlinologists from days past.
Who is standing next to whom at the May Day parade has been replaced by which words have been added or deleted from the minutes of meetings.
Not only do the stock and bond markets move solely in relation to the Federal Reserve, but the Federal Reserve acts only in relation to the stock market. It’s like they’ve formed some sort of binary black hole system.
A key reason why wealth managers applaud dovish Federal Reserve comments and actions, and a key reason why the Federal Reserve acts as such, is the mistaken believe in the “wealth effect”.
They believe that by increasing wealth through rising stock and housing prices, the populace will increase their consumer spending which will spur economic growth.
Regardless as to whether or not increased wealth will actually spur increased consumer spending, the most important component of the wealth effect is the assumption that increased consumer spending stimulates economic growth.
It is a pure Keynesian concept and it is critical to the wealth effect’s validity. If increased consumer spending fails to stimulate the economy, the theory of the wealth effect fails. Wealth effect turns, in effect, into wealth defect.
Does increased consumer spending improve the economy? On one side of the argument, we have the aggregate individual conclusions of hundreds of millions of economic actors, each acting in their own best interest. These individuals and businesses are attempting to reduce consumer spending and increase savings.
Dissenting from their views is Board of Governors of the Federal Reserve. Each member appears to believe in the paradox of thrift – the belief that increased savings, while beneficial for any particular economic actor, have negative effects for the economy as a whole.
The paradox of thrift can essentially be described as this: decreased consumer spending lowers aggregate demand which reduces employment levels which negatively affects consumption which in turn lowers aggregate demand. The paradox predicts an economic death spiral from diminished demand.
But history suggests the opposite: it is higher savings rates which lead to economic prosperity. Examine any economic success story such modern China, 19th century America, or postWWorld War II Japan and South Korea: did their economic rise derive from unbridled consumption, or strict frugality?
The answer is selfWevident: it is the savings from the curtailment of consumption, combined with minimal government involvement in economic affairs, which generates economic growth.
So why do so many wealth managers and economists falsely believe in the paradox of thrift, and thus the wealth effect? It is because of their mistaken understanding of the nature of savings. They believe savings leak out of the economic system and are never spent.
But savings are indeed spent. Not directly by consumers on electronics and espressos, but indirectly by businesses via banks on more efficient machinery and capital expansions. Increased savings may (initially) negatively affect retail shops, but it benefits producers which create the goods demanded from the increased pool of savings. On the whole, the economy is more efficient and prosperous. So, to what investment advice do these economic fallacies lead? What errors are being inflicted upon one’s portfolio?
Without fear of either inflation or recessions, wealth managers have no understanding of interest rates, and thus see no danger in bonds.
It is somewhat understandable. Given the recent history of massive intervention in the bond markets by central banks, few remember that interest rates are ultimately a product of the free market.
At a fundamental level, interest rates reflect the time preferences of various actors within the economy. Add in assessments of credit risk as well as expectations of future price levels, and a structure of interest rates over various time frames is revealed.
All markets can be suppressed, distorted, or manipulated, but only for a limited time. The bond market is no different; whether through a sober assessment of credit worthiness by investors or via rising price inflation, the market will compel higher interest rates.
For this reason, the U.S. government has suppressed interest rates for years: it simply cannot afford for them to rise. It will continue to do so by remaining reliant (and increasingly so) upon the printing press to purchase bonds to lower rates. But this strategy will only work for so long.
In Human Action, Mises wrote:
Nobody believes that the states will eternally drag the burden of these interest payments. It is obvious that sooner or later all these debts will be liquidated in some way or other, but certainly not by payment of interest and principal according to the terms of the contract.
If the Federal Reserve continues with proliferate production runs of the printing presses, expect Mises to be prophetic: bondholders will be “repaid”, but with a currency which hardly meets the “terms of the contract.”
Wealth management’s enthusiasm for stocks and bonds is matched only by their hostility to such inflationary recession protections as precious metals, private lending, and certain types of real estate such as farmland and rental residential properties.
The hostility to gold can be seen by its widespread exclusion from recommend investment allocations. It can be seen by the fact that the value of all of the gold in the world ever mined is dwarfed by the national debt of the U.S. It can be seen by the fact the entire gold mining industry is easily dwarfed in value by a number of individual U.S. stocks.
The fact advisors ignore such major asset classes as farmland is a great example of the problems with the wealth management industry. For even if they heeded the dangers of inflation and recessions, they could not consider farmland within their portfolios.
The reason is that there are very few public farmland vehicles – Real Estate Investment Trusts – or REITs, in the
U.S. Accordingly, there are no investment benchmarks for farmland to be considered by wealth advisors (because the sample size is too small).
Therefore, wealth advisory firms will not consider an investment in farmland. Mind you, it’s not because the investment opportunity doesn’t exist, rather it is because wealth managers cannot be viewed as performing out of sync with commonly used real estate investment benchmarks. To do otherwise will entail risking their careers.
This is the real problem in the wealth advisory industry – advisors are worried about losing clients, not with losing clients’ money. Wealth advisors are happy tracking what everyone else is doing – because in so doing, they believe they are preventing their clients from switching to another firm. This “career risk” syndrome forces wealth advisors into shortWterm outlooks and a herdWlike mentality.
Wealth managers really manage money, not wealth. Wealth is beyond that of money and includes such things as health, judgement, and knowledge – basically everything that helps bring about our happiness.
But money is a critical component. It grants optionality and the means to make choices.
Mises understood this and embodied it in the concept of acting man – the motivation to increase one’s level of satisfaction.
The best way to maximize your satisfaction Wyour wealthW is to make sure your portfolio is guided by Austrian economic theory.
ChristopherP.CaseyisaManagingDirectorwithWindRock Wealth Management. Mr. Casey advises clients on their investment portfolios in today’s world of significant economic and financial intervention. He can be reached at 312O650O9602 or chris.casey@windrockwealth.com.
WindRock Wealth Management is an independent investment management firm founded on the belief that investment success in today’s increasingly uncertain world requires a focus on the macroeconomic “big picture” combined with an entrepreneurial mindset to seize on unique investment opportunities. We serve as the trusted voice to a select group of high net worth individuals, family offices, foundations and retirement plans.
All content and matters discussed are for information purposes only. Opinions expressed are solely those of WindRock Wealth Management LLC and our staff. Material presented is believed to be from reliable sources; however, we make no representations as to its accuracy or completeness. All information and ideas should be discussed in detail with your individual adviser prior to implementation. FeeWbased investment advisory services are offered by WindRock Wealth Management LLC, an SECW Registered Investment Advisor. The presence of the information contained herein shall in no way be construed or interpreted as a solicitation to sell or offer to sell investment advisory services except, where applicable, in states where we are registered or where an exemption or exclusion from such registration exists. WindRock Wealth Management may have a material interest in some or all of the investment topics discussed. Nothing should be interpreted to state or imply that past results are an indication of future performance. There are no warranties, expresses or implied, as to accuracy, completeness or results obtained from any information contained herein. You may not modify this content for any other purposes without express written consent.
Velocity Lacks Veracity
Christopher P. Casey
Typically defined as “the number of times one dollar is spent to buy goods and services per unit of time,” historically low monetary velocity is blamed for stymieing the Federal Reserve’s ability to achieve a targeted rate of price inflation.1 It is cited as delaying the onset of price inflation which was imminently predicted by some financial commentators in the aftermath of the Great Recession. It is viewed by all as problematic as it is powerful, as vexing as it is valid. Yet, despite its nature and magnitude having been debated for decades between Keynesian and Monetarist economists, monetary velocity is simply a pervasive and damaging myth.
The concept of velocity derives from the Fisher Equation of Exchange: MV=PT, where the quantity of money (M) times the velocity of its circulation (V) equals prices (P) multiplied by their related transactions(T). Initially developed by Copernicus, its modern manifestation was promulgated by the economist Irving Fisher in 1911.2 3 The equation attempts to explain increases (or decreases) in the price level: if the quantity of money expands, then prices will rise unless velocity decreases (or if transactions increase).
Valid criticisms of velocity are numerous: that the equation is merely tautological (it should be self-evident that prices paid for goods and services equal the prices charged for such goods and services), that the velocity of money cannot exist apart from the circulation of goods and services, that velocity is an effect and not a cause of price movements, etc. All of these arguments, while completely correct, avoid the primary reason velocity confuses mainstream economic prophets and financial prognosticators alike, for any theory of prices cannot ignore the demand for money. Murray Rothbard recognized this as the Fisher Equation’s fatal flaw: “it is this profound mistake that lies at the root of the fallacies of the Fisher equation of exchange: human action is abstracted out of the picture.”4 The abstraction of human action means the absence of monetary demand.
Why the Fisher Equation is Wrong
Without the foundation of the Fisher Equation, velocity loses any theoretical justification. Historical examples of price inflation failing to correspond with the mechanistic workings of the Fisher Equation demonstrate the equation’s falsehood. In the “Velocity of Circulation” (from Money, the Market, and the State), Henry Hazlitt shattered the Fisher Equation and underscored the importance of monetary demand by describing the historical behavior of price inflation:
What we commonly find, in going through the histories of substantial or prolonged inflations in various countries, is that, in the early stages, prices rise by less than themiddle stages they may rise in rough proportion to the increase in the quantity of money . . . but that, when an inflation has been prolonged beyond a certain point, or has shown signs of acceleration, prices rise by more than the increase in the quantity of money.5
In losing the formulaic correlation of the Fisher Equation, velocity drops all claims to causation. But not only does the Fisher Equation fail to comport with historical fact patterns, it also rejects basic economic theory. Almost all economists today recognize that the price for any particular good or service derives from the interaction of supply and demand. The Austrian economists, since the 1912 publication of Ludwig von Mises’ Theory of Money and Credit, have applied this logical and consistent principle to the concept of money:
The changes in the purchasing power of the monetary unit are brought about by changes arising in the relation between the demand for money, i.e., the demand for money for cash holding, and the supply of money.6
The “price” of money derives from the same supply and demand dynamic as any good or service. In excluding monetary demand, the Fisher Equation loses all explanatory authority. And velocity cannot purport to act as a proxy for monetary demand.
Why Velocity is Not Monetary Demand
Velocity is not a substitute for demand, but rather of volume. Lots of goods and services may transact at low prices just as they may trade at high prices. In either scenario, “velocity” is high while the demand for money may be low or high. The situation is analogous to daily price changes in the stock market: equity indices may fall or rise significantly (largely a function of demand as the supply of shares is fairly consistent from day to day) with large or little trading volume. In either scenario, price levels are invariant to volume. As such, velocity lends no insight or description of demand for any good or service – or money.
What is the demand for money, and what influences it? The demand for money is the desire for particular levels of cash holdings. In Man, Economy, and State, Rothbard detailed monetary demand’s constituent parts as the exchange demand for money (the degree to which holders of goods and services wish to trade for money) and the reservation demand for money (the degree to which current holders of money wish to keep it). Regardless, the desire for cash holdings depends upon an ever-changing determination of values and preferences by economic actors. It is certainly influenced by future uncertainty, expectations as to future purchases, and anticipated future price levels. The criteria influencing monetary demand are as myriad and complex as the nature of the various economic actors desiring cash holdings.
Conclusion
In divorcing monetary demand from the determination of purchasing power, the Fisher Equation detaches price level analysis from reality. Rothbard recognized its negative potential when he described it as “at best . . . superfluous and trivial, at worst . . . wrong and misleading.” The latter situation exists with the Federal Reserve’s false focus on monetary velocity as an impediment to their stated price inflation targets. To overcome this bogus barrier, the Federal Reserve will continue to increase the money supply. When significant price inflation develops, the realization of this mistake, if they realize it at all, will be too late.
Endnotes:
St. Louis Federal Reserve.
Rothbard, Murray. Economic Thought Before Adam Smith (Edward Elgar Publishing Ltd., 1995).
Fisher, Irving. The Purchasing Power of Money (New York: Macmillan, 1911).
Rothbard, Murray. Man, Economy, and State (William Volker Fund, 1962).
Hazlitt, Henry. “Velocity of Circulation” from Money, the Market, and the State, (Athens, Georgia: University of Georgia Press, 1968).
von Mises, Ludwig. Theory of Money and Credit (New Haven, Connecticut: Yale University Press, 1953).
About WindRock
WindRock Wealth Management is an independent investment management firm founded on the belief that investment success in today’s increasingly uncertain world requires a focus on the macroeconomic “big picture” combined with an entrepreneurial mindset to seize on unique investment opportunities. We serve as the trusted voice to a select group of high-net-worth individuals, family offices, foundations and retirement plans.